Fix Your 401(k)

At too many companies, critics say, the 401(k) plan is in so-so shape. Can savvy employees patch the holes and improve their odds of a secure retirement?

By

IanSalisbury

Every day, millions of Americans give their investments the serious attention they deserve, riffling through the business pages, tracking the markets and grappling with tough questions. Do I need more exposure to stocks -- or less? How worried should I be about the euro? Am I going to need to save more to retire on time? But there's a major question often hiding in plain sight, one so fundamental to people's financial health many don't even think to ask it: Is my 401(k) plan any good?

Certainly, few of us need to ask whether the plans matter: We've resigned ourselves to our dependency when it comes to retirement savings. Americans now hold $4.3 trillion in 401(k)s and similar defined-contribution plans, nearly three times as much as the $1.6 trillion parked in annuities. The plans weren't originally designed to be the nation's primary retirement lifeline -- they started as a minor tax perk for senior executives -- but they've grown inexorably, as ever more big companies have used them as a cheaper alternative to traditional pensions. Only about a third of the corporate work force can look forward to a monthly pension check today, down from 80 percent three decades ago; over the same period, assets in 401(k)-like plans have grown 16-fold.

And yet, as many economists and money pros know and as more employees are beginning to realize, the plans are riddled with problems capable of tripping up even the most diligent investors. The laundry list of pitfalls includes high (and often hidden) expenses that eat up enormous chunks of plan members' gains, as well as company-provided advice that critics say ranges from vague to nonexistent. Some consumer advocates say that too many employers treat their plans as an afterthought -- and that the financial-services industry, which collects between $30 billion and $60 billion a year in fees from such plans, has little incentive to change things. So it often takes Norma Rae-like activism to get a company to improve its plan lineup -- which means that, for many Americans, picking the components of their 401(k) may be the biggest financial decision they never get to make. "I personally think the 401(k) should be abolished," says Matt Goff, a Houston financial adviser whose practice serves small-business owners needing help with their company retirement plans.

To be sure, some conscientious companies are working to make their plans better; federal regulators are getting involved too, with new rules that may make it easier for investors to see what they're actually paying for their plans. But for most investors, advisers say, it doesn't make sense to wait for the cavalry to come. Here, some of the best advice for cutting costs, finding better funds or even going outside an employer's plan to launch a 401(k) repair project.

The New "Target": Cutting Costs

Americans now hold $343 billion in target-date funds, up threefold in six years, and they're buying them mostly through their retirement plans. These funds are the cafeteria lunch of mutual funds: They include all the basic food groups, so investors don't have to order à la carte. The funds invest in a mix of stocks, bonds and other investments that gets more conservative as an investor's retirement, or target date, approaches, rebalancing automatically for investors who prefer not to or don't know how to do it themselves. Congress passed a law in 2006 making it easier for employers to use target-date funds as a default 401(k) option, and 81 percent of large employers now offer them.

But for some cost-conscious investors, the expenses built into target-date funds are a growing peeve. Most such products are "funds of funds" that spread assets among multiple other investment vehicles. As a result, target-date-fund expenses span an unusually wide range. Vanguard's target-date products, which rely heavily on index funds, have average expenses of $18 a year per $10,000 invested; at the opposite extreme, Oppenheimer uses actively managed funds and charges $168 per $10,000. And investors at smaller companies are more likely to face fees at the higher end of the range. The differences can add up. According to human resources consultant Towers Watson, an increase of just $50 per $10,000 in target-date-fund fees could cost a high earner the equivalent of eight years' worth of retirement savings over the length of his career.

Target-Date Funds: What to Ask

How did you do in the crash?

Planners say that anyone considering a target-date fund should see how that fund fared during the 2008-09 financial crisis. Among target-date funds geared for workers who planned to retire in 2010, the average fund lost 22 percent in 2008, but some lost as much as 40 percent.

Am I the kind of investor you target?

Target-date funds have a lot of assumptions about investor behavior baked into their structure. Many hold plenty of volatile assets, like stocks, even as they pass their retirement target dates, assuming investors won't need to tap the money right away and can take some risks with it. Others are already filled with bonds, assuming that investors will cash out the day they retire. Savers whose needs or plans don't match a fund's assumptions might not find the funds to be a good fit.

Can I get your funds separately -- and cheaper?

Some investors and advisers check a target-date's overall expense ratio, then compare that fund's individual components to similar index funds in the same 401(k) plan. In some cases, employees find they can build a comparable portfolio at a fraction of the cost.

Do you diversify me?

Some investors say it can be worth holding on to a target-date fund if it offers investments that you can't get elsewhere in your 401(k), like commodities or REITs, which can smooth returns in rocky markets.

To be sure, some investors say it's worth paying more for the convenience of the all-in-one funds; what's more, the funds sometimes have access to assets like gold or foreign stocks that employees can't get elsewhere in the plan. Still, some do-it-yourselfers are opting to cook from scratch rather than accept the cafeteria tray. Atlanta adviser Jeffrey Baumert, who helps small-business owners design plans, says he'll sometimes encourage folks whose plans include Fidelity's Freedom funds to try an alternative. Freedom funds' expenses average $74 per $10,000, and Baumert says his clients can do better -- they can get exposure to large-cap stocks, for example, through the inexpensive Fidelity Spartan 500 Index fund. "Do you really think that all their fund managers in every category are going to be the best?" he asks. (Fidelity says its active management is designed to deliver better returns in the long run.)

Some advisers advocate an even simpler rule of thumb: When possible, use only index funds. That's because the typical 401(k) fee structure makes the substantial expense gap between indexes and active funds even wider. "Packagers" -- companies like Fidelity, Vanguard or other middlemen -- collect a substantial share of their 401(k) plan revenues from active funds. Active large-cap stock funds, for example, route an average of $21 per $10,000 invested to cover back-office expenses like accounting and record-keeping, according to human resources consultancy Aon Hewitt (a firm which itself sometimes acts as a packager). The average large-cap index fund, in contrast, routes just $6, and at least half such funds don't charge those fees at all. Ultimately, investors in actively managed funds are subsidizing their coworkers, says Dave Gray, head of retirement plan product development at Charles Schwab; using index funds means getting that subsidy, instead of paying it.

Comparing Plans on Cost

Soon, employers will be required to make more detailed disclosures of their plans' costs. But for more data, experts say, investors will still have to dig into companies' regulatory filings.

Cheap: IBM (Plan run by Fidelity)

The sheer size of the plan, which has more than 200,000 participants, helps keep costs down, since bigger 401(k) programs usually get heftier discounts on fund expenses. But the plan also emphasizes cheaper index funds, including index options for real estate investing and inflation-protected bonds.

Average: Abercrombie & Fitch (Plan run by Fidelity)

Members of the fashion retailer's plan have access to some index options, but most of the choices are more costly, actively managed funds, including Fidelity's target-date funds. (Fidelity says the active management of those funds gives investors a long-term performance edge.)

Expensive: Take-Two Interactive Software (Plan run by The Principal Group)

Most funds in the video-game maker's plan are more expensive than average. To use the main stock index fund, employees pay $42 per $10,000 invested, more than twice what an all-but-identical fund costs outside the plan. Principal says the costs are typical for a plan of this size.

Expanding Your Choices: The 401(k)-Plus

When the U.S. financial system went haywire in 2008, many Main Street investors started searching for commodities, foreign bonds and other alternative investments that had a chance to stay afloat when U.S. stocks sank. But if they went looking in their 401(k)s, advisers say, chances are they found nothing -- and, more surprising still, even now, many plans haven't adapted. Excluding target-date products, the average plan has just 13 funds, only one more than before the crash, according to Aon Hewitt. And the very categories they're missing are the ones that employees could be using to hedge against a choppy stock market. Less than half of plans have a bond index fund, for example, and only about one in four includes real estate funds.

A minority of larger 401(k)s give their employees a relatively simple way to get what they're missing, sponsoring a "brokerage window" that lets investors buy funds that aren't in the plan lineup, along with stocks and ETFs in some cases. But for many employees, experts say, it's a costly proposition. Trading commissions tend to be noticeably higher on such transactions than on the same ones made through a discount broker, for example, and investors won't get the "institutional" discount on fund shares. The result is you'll pay more for the investments you want -- "like buying hot dogs at the ballpark," says financial adviser Robert Schmansky, who helps employers choose 401(k) plans.

Beyond Your 401(k): What to Ask

What's my match?

Financial advisers say investors should almost always contribute enough to get their 401(k) plan's full match -- most years, their investments would have to have a great run to make up for the money they would have left on the table.

Can I climb out the window?

About a fifth of large companies have a "brokerage window" that offers access to a bigger range of investments -- though using it means paying fees and commissions. Some advisers recommend minimizing costs by using the window only once a quarter or once a year.

What if I go out on my own?

Investors without a brokerage window can find more investment options by opening an IRA or a Roth IRA. For 2012, the maximum contribution for such plans is $5,000 for those under 50 and $6,000 for those 50 and older.

When can I leave?

When workers switch jobs, they can roll their 401(k) plan balance into an IRA. Otherwise, they're stuck, with one noteworthy exception: In many plans, those who turn 591/2 become eligible for an "in-service rollover," even if they stay with their company.

The upshot is that some employees have decided, in a sense, to take the money and run. They contribute just enough to their plans to get a company match, then set up separate retirement accounts that can fill the holes in their 401(k)s. Aircraft giant Boeing has leveraged its huge work force -- its 401(k) has around 200,000 enrollees -- to get low fees in its plan, which includes plenty of low-cost index funds. But the plan lacks funds that focus on holdings that money managers say can help smooth returns in rocky markets, including REITs and Treasury inflation-protected securities. It also lacks specific funds for emerging-market and foreign small-cap stocks. As a result, advisers say, many Boeing employees have built their own shadow 401(k)s. Lowell Lombardini-Parker, a financial planner in Seattle, says he's dealt with dozens of clients from the company, helping them buy low-cost funds targeting those asset classes. His philosophy: "Use what you can. But if you have to, go outside the 401(k)." (Boeing says its own plan includes a "prudent" menu, and that its narrow range of options is designed to not overwhelm unsophisticated investors.)

The double-barrel strategy isn't necessarily the right fit for everyone. Because a matching contribution from an employer is essentially free money, planners say investors should always collect fully on that. And higher-income workers may not be able to make tax-deductible contributions to outside accounts if they also have a 401(k). In that case, Lombardini-Parker says, it may still make sense to put money in a taxable retirement account. Many advisers recommend that investors leave REITs and TIPS out of such accounts -- since they tend to throw off taxable income -- and use them instead for equity funds and other stock investments that they plan to hold for a while.

Where the Advice Is... and What It Costs

Advice From Your Company

Cost: Usually free.

Pros: Can't beat the price.

Cons: Only offered by about 60% of firms. Many limit counsel to relatively generic advice.

One-Time, Outside Advice

Cost: $500 and up for a review of your finances (based on typical fees).

Pros: Clients can mesh 401(k) advice with counsel on issues like college savings and insurance.

Cons: It's up to the client to follow the plan; getting follow-up advice often means paying extra.

Full-Time Advice

Cost: Typically 1% a year, or $5,000 a year for someone with $500,000 in investable assets.

Pros: Advisers handle some transactions for clients and offer guidance on issues like estate planning

Cons: Often more expensive than part-time help; some investors with fewer assets feel neglected.

Summoning Reinforcements: Outside Help

On average, 401(k) members fork over $83 per $10,000 invested each year in total fees, according to a recent study by Deloitte Consulting and the Investment Company Institute. For about 60 percent of 401(k) plans, that fee comes with what looks like a corresponding perk -- the opportunity to get investment advice. But according to the Plan Sponsor Council of America, a trade group, only about one in five investors takes advantage of the advice.

Why so little interest? It turns out that the companies' offerings are pretty bare-bones. David Wray, president of the plan council, says the threat of lawsuits means large companies need to make sure that, say, a 60-year-old in Dallas and a 60-year-old in Boston get relatively consistent recommendations, which means the advice is less likely to be personalized. Employers also almost always avoid offering advice about any assets that aren't in the 401(k), like a home or a spouse's savings. The result: "Plan-provided advice tends to be generic," says Wray.

The problem, of course, is that anything that isn't generic can get expensive. Financial advisers can spend hours poring over every investment choice. But their fees often start at 1 percent of an investor's assets, which would effectively double what the typical 401(k) shareholder is already spending on her portfolio. One Goldilocks option: Some financial planners will take on smaller advice projects, counseling investors on a one-time basis for an hourly fee. Brian Terry, a Charlotte, N.C.-based adviser, has seen dozens of 401(k) clients. He gives his clients a rundown of their plan, taking a few hours to help them pick investments; many, but not all, return once a year for a follow-up. His price: $150 an hour. The Garrett Planning Network is one network of hourly-fee planners; others can be found through the National Association of Personal Financial Advisers.

Financial planners have their own idiosyncrasies and agendas, though, and some critics complain that they can drive people into cookie-cutter strategies of their own. Consumer advocates say investors should check whether advisers get compensated for recommending any particular investments (a common arrangement among both independent operators and employees of big-name brokerages). When it's time to talk 401(k), advisers say, preparation counts: Think carefully about when you want to retire and how much money you hope to spend, says Lea Ann Knight, a planner from Bedford, Mass., who meets with many clients for similar consultations. And don't be shy about secret ambitions -- like that condo in Maui. Devote your face time with the planner to these goals; let him parse the fine print on investment prospectuses.

And investors who decide that with or without help, their 401(k) just won't cut it can always approach the boss. Retirement consultants say that many employers, no less befuddled by the system, are often happy to hear what employees want. Of course, some may have better luck asking employers to add a single option like a mutual fund than to switch providers entirely. One place to start: Grassroots investing website Bogleheads.org has a form letter employees can download for free.

Getting Help: What to Ask

Should I take my employer's advice?

Pros say advice from planners hired by the employer can offer investors a quick read on how much to save or whether to buy more stocks or bonds. But when it comes to picking specific investments, they add, getting a second opinion or reviewing independent research is often worthwhile.

What's online?

Morningstar is an invaluable resource for researching mutual funds. At not-for-profit website Bogleheads .org, anyone brave enough to (anonymously) post the details of their financial life can get advice from opinionated volunteers. Of course, with free and anonymous advice, "it's buyer beware," says securities lawyer Edward Rosenblatt.

Can I find out how my plan stacks up?

BrightScope, a financial research firm, has a website that offers ratings of 401(k) plans: The sections on "total plan cost" and "investment-menu quality" offer a sense of how a plan's fund lineup stacks up against others in its industry.

What kind of adviser do I want?

For those whose main financial concern is their 401(k) plan, a one-time meeting with a planner can be cost-effective; for investors with more complex needs, like an inheritance or college education to finance, bringing on someone full-time for an annual or asset-based fee might be warranted.

Intraday Data provided by SIX Financial Information and subject to terms of use. Historical and current end-of-day data provided by SIX Financial Information. All quotes are in local exchange time. Real-time last sale data for U.S. stock quotes reflect trades reported through Nasdaq only. Intraday data delayed at least 15 minutes or per exchange requirements.